Theories of Exchange Rate Determination - Essay Example

Infact before exploring various exchange rate models it is worth looking at how a wrong assessment of the exchange rate can cause difficulties where as in the past various corporations have dealt with and suffered the burnt of foreign currency transaction risk. Millman(1990,1995) gives some interesting examples in his research work. One example he gives is of Lufthansa,the German airline which when contracted with Boeing to purchase aircrafts in the 1980's ,the value of the dollar was rising.

The price of the aircrafts were set in dollars. Lufthansa feared that the dollar would strengthen and the cost in . Deutsche marks would increase the cost of the planes. Therefore it entered into forward contracts for the dollars required to pay for the planes.Contray to expectations the dollar weakened. Due to its wrong speculation forward contracts cost Lufthansa $140 to $160 million more for the aircrafts that they would have if they had bought the dollars on the spot market(Millman 1990).

Although then there is no reliable way to counter forex risk in foreign markets it now worth looking at the various exchange rate models and how they have shaped forex and macroeconomic policies to avoid unexpected risks especially in financially volatile markets much affected by political repercussions and unpredictable events.Introduction to forex theory and its determinationThere are various theories of exchange rates which tend to produce various estimates of the exchange rate .This is not mainly due to the application of different theories however as varying econometric methods may also cause this variation and this has also caused doubt as to their efficacy and credibility as reliable estimates of a country's forex reserves.

In this vein my paper will explore three of the existing theories pertaining to forecasting the exchange rate movements in the light of their empirical and micro foundations. This will be discussed according to their preconditions, implications and advantages and disadvantages.PPP approachFirstly we have the purchasing power parity approach to the exchange rate which has empirically found a lot of support and has influenced a lot of economic thought. The crux of this approach lies